The United States has experienced financial accountability failures over the previous decade that has resulted in an overall lack of stakeholder confidence. Trust is an important characteristic needed in the economy because it can attract investment dollars. Just the opposite is true when there is a lack of trust – investors are far less likely to sink money into a system where scandal is prevalent. The trust issue is perpetuated by businesses that have executives who engage in the manipulation of the financial reports through the use of Generally Accepted Accounting Principles (GAAP). While the manipulation varies from immaterial to material misrepresentation and fraud, the overall belief is that GAAP is a rules-based system that is overly general in nature and can be skewed by business leaders to illustrate financial health metrics that may not be fully transparent. This paper provides brief examples of GAAP failures in the recent past, sheds light on the framework of GAAP that can be manipulated, and then offers solutions that will help the accounting profession in the United States to regain user trust.
GAAP principles are the guiding force of accountability in the finance profession. The preparation of financial statements for any publically traded company is contingent upon these guidelines. The problem with GAAP is that the framework has been manipulated to the extent of providing uncertainty in the presentation and interpretation of those statements by the user. The problem is so pervasive that a common workaround strategy within the investment community is to always consider non-GAAP financial measures when assessing a U.S. company. Unfortunately, due to this distrust and lack of true transparency, the purest way to review a business in the U.S. is often found in using metrics such as free cash flow, adjusted income from operations, reporting discontinued operations, and pro forma earnings. Users should not have to use any special approach to value a company or assess financial health. An investor should simply be able to review the income statement, balance sheet, and statement of cash flows to get the lion’s share of the pertinent information. The answer to this dilemma is found in adopting a principles-based system of accounting in lieu of the rules-based system the U.S. has under GAAP.
The U.S. must continue the convergence of GAAP principles with IFRS if the accounting profession is to regain trust in the market. Convergence in accounting principles is simply the strategy of adopting a single set of rules that can be used globally. Most importantly, this is the goal of reducing the weaknesses found in GAAP in lieu of the strengths of IFRS. The weaknesses are defined by their inherent capacity to attract manipulation. While convergence has already started in several areas of GAAP, the effort must be pushed further. This is evidenced by the continued examples of scandal and fraud that are seemingly inherent to GAAP. The U.S. Financial Accounting Standards Board also agrees – “Investors, companies, auditors, and other participants in the U.S. financial reporting system should benefit from the increased comparability that would result from internationally converged accounting standards.” For the purposes of this paper, the Financial Accounting Standards Boards express their interest in providing investors with a transparent set of financials through the convergence of IFRS.
W.R. Grace and Company is an example of a business that was charged with committing earnings fraud. The Company was caught saving earnings back during particularly fruitful accounting cycles and then reporting those earnings in later months when business slowed down. McKesson Incorporated is another example of a company found guilty of earnings fraud. The accountants at the Company recorded revenues based upon future earnings expectations. Essentially, while business contracts were being finalized, earnings were reported based upon future business transactions. The investigation resulted in the firing of a handful of Company executives. The landmark case of earnings manipulation was Enron. According to Alexei Barrionuevo at the New York Times (2006) an Enron accountant testified at trial that “he manipulated earnings on two occasions after receiving directions from Enron corporate officers that they wanted to beat analysts' estimates for each quarter. In both cases, he said, he dipped into a $70 million reserve that had been set aside for a contract settlement with a utility.” Enron was one of the largest financial scandals of recent history. After the investigation into the manipulation at Enron was complete, it was seen that the Company had recorded earnings and assets that were inflated. While some of these reports were found to be fraudulent, some were found to be acceptable under the GAAP’s rule-based system.
GAAP has several avenues of manipulation that lead to dishonest accounting practices. The first being earnings. According to Makar, Alam, and Pearson (2000) “GAAP allow an accountant to select from various methods when computing earnings, which could lead to lower quality financial information depending on the accounting methods used.” The quality of the financial information mentioned is a measurement of how accurate the financials illustrate economic truth. In addition, “company managers can manage earnings subjectively by timing business activities or the reporting of those activities” (Makar, Alam, Pearson, 2000). This activity, while legal, is a method of manipulation that can be implemented by business executives to skew earnings and paint a picture that is not fully transparent. This behavior among business leadership only becomes a case of fraud when it can be proven that the executives purposefully provided a material misrepresentation of the numbers.
A second area of manipulation under GAAP is the reporting of operating income. Because operating income is not well defined under GAAP due to the classification lines being discretionary, it attracts manipulation. Transactions that are funneled through this line item can be chosen by a financial manager. For example, non-reoccurring income from unusual events can be omitted or integrated into operating income to present a number that is good for the shareholders. Third, sales figures and gross profit are also able to be manipulated under GAAP. The classification of sales as being a gross amount billed or an expected amount to be received in the future is subject to manipulation. Shipping and handling expenses can be included in the sales figures, or not included in the sales figures to manipulate reported sales revenue. While these manipulations do not impact the financial reports like fraudulent sales numbers, it does still show an inflated or reduced figure that works to misrepresent economic representation and encourages distrust among stakeholders.
Due to the heavy manipulation, intense scrutiny, and a convergence of international accounting, GAAP is due for an upgrade. The International Financial Reporting Standards (IFRS) provides a tangible option to improve or entirely replace GAAP in the U.S. IFRS is considered a rule-based system of accounting that provides much more detail in reporting standards and improves transparency. The goal of IFRS is to provide financial statements that reflect the economic image of the sum of all business transactions. By providing more economic principles oversight in the accounting system, this limits the options of manipulation that flow through financial statements. The IFRS sets economic principles that define exactly how each transaction should be reported and what numbers show up on the resulting income statement, balance sheet, and statement of cash flows.
The valuation methodology of intangibles is one example of IFRS being considered a more principles-based system. Under U.S. GAAP intangibles are realized at a fair value. Under IFRS intangibles are not recognized unless it’s an asset that will produce a future benefit economically that has reliability in measurement. Essentially, GAAP allows for intangible asset valuation that is highly flexible and subjected to manipulation. IFRS provides a much more economically feasible and appropriate valuation that removes the option of manipulation. The accounting for inventory is another example of the weakness of GAAP that leads to user distrust. IFRS does not allow for the last in first out inventory cost method; however, under GAAP the last in first out method can be used. Due to the natural tendency of inventory costs to rise, allowing a last in first out method weighs the cost of inventory to be recognized prematurely. This benefits the company by increasing costs against sales and reduces tax liability. The last in first out method is not considered to be fraudulent or illegal; however, some argue that it doesn’t accurately portray the attachment of cost to revenues in the accounting cycle in which the transaction occurs.
The adoption of IFRS in lieu of GAAP’s flexible approach will allow for the accounting profession to regain its trust. As the international market converges to create a single global economy, IFRS will allow for enhanced comparability between firms. SEC Chairman Cox (2008) conveyed in a press release “IFRS is used in some form by more than 100 countries, mandatory in 30 of those 100, in more than 12,000 firms; this represents 33 percent of the international market capital.” Trust can be built when investors can compare businesses that use the same set of standards to prepare the financial statements.
Currently, comparing many U.S. based firms to those abroad is an ‘oranges to apples’ comparison. It is nearly impossible to arrive at an ‘apples to apples’ comparison of two firms that are operating under two different accounting standards. Since accounting is the language of business, trust can be improved in the system through the adoption of a single set of accounting principles that are used across the globe. The adoption or convergence of IFRS in the U.S. financial system will allow investors to compare various companies equally as they will be using the same principles and methodologies to present the financial health of their respective organizations. This creates an environment of trust where investors can use financial data to decide where they should invest their money. According to the American Institute of Certified Public Accountants (2008) “by adopting IFRS, a business can present its financial statements on the same basis as its foreign competitors, making comparisons easier. Furthermore, companies with subsidiaries in countries that require or permit IFRS may be able to use one accounting language company-wide.”
In conclusion, user trust can be reaffirmed into the U.S. financial system with a few key progressions. First, it will be necessary to remove the flexibility in the system that has opened the door of manipulation and establish a strict set of guidelines to be used by the finance profession to construct the set of financial reports. Unfortunately, flexibility drives people to use that tool as an advantage to skew numbers in financial statements. The areas of manipulation such as earnings, inventory, and expense smoothing can be taken away under GAAP and replaced with a principles-based system of accounting found in IFRS. Since the responsibility of providing financial statements comes with an expectation of transparency, trust is ruined when scandal hits and stakeholders realize that the whole system could be a fraud. Once the sentiment is realized, like in the case of GAAP, it is impossible to assert trust into the system without drastic change. The Enron scandal provides a case study to the detriments of allowing a system of accounting that is flexible. Enron is well known because of the business size and scope; however, the paper has provided other examples of misrepresentation, fraud, and distrust. Due to the heavy manipulation, intense scrutiny, and a convergence of international accounting, GAAP is due for an upgrade. The U.S. must continue the convergence of GAAP principles with IFRS if the accounting profession is to regain trust in the market.
American Institute of Certified Public Accountants. (2008). “International Financial ReportingStandards”. Retrieved on October 14, 2013 from, http://www.ifrs.com/updates/ aicpa/ifrs_faq.html#q5
Barrionuevo, A. (2006). “Enron Figures Tell How Results Were Manipulated.” New York Times.Retrieved on October 14, 2013 from,http://www.nytimes.com/2006/02/28/business/businessspecial3/28enron.html?_r=0
Cox, C. (2008). “Proposing a Roadmap Toward IFRS.” Retrieved on October 14, 2013from, www.sec.gov/news/speech/2008/spch082708cc_ifrs.htm.
FASB. (2012). International Convergence of Accounting Standards Overview. Retrieved onOctober 14, 2013 from,http://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1176156245663
Makar, Alam, and Pearson. (2000). “Earnings Management.” Fraud Magazine. Retrieved onOctober 14, 2013 from, http://www.fraud-magazine.com/article.aspx?id=4294968448